Electricity Market Design

From 1989 to his formal retirement, David led UK Research Council-funded energy market research, and this has been the main focus of his research since then. His work in this area was substantially driven by real-world events in the energy market in the UK, which made ‘the British Electricity Experiment’ a world-famous case study in market liberalisation.

The British electricity industry was substantially restructured and privatised in 1990. A key feature of the process was the break-up of the monopoly Central Electricity Generating Board (CEGB). This involved separating the ownership of power plants from the transmission grid and the creation of a competitive wholesale power ‘pool’ with half-hourly price bidding by individual power plants to meet demand (i.e. a vertical and horizontal unbundling of the incumbent monopoly). David’s third most cited paper, published in 1992 with his then DAE colleague Richard Green, looked at ‘Competition in the British Electricity Spot Market’. The CEGB was broken up, but the wholesale market was effectively a duopoly, with National Power and PowerGen controlling 90% of the price-setting power generation plants in the pool.

Green and Newbery analyse the optimal bidding strategies of duopolists in such a power market using supply function equilibria (following Klemperer and Meyer 1989). In a supply function equilibrium setting, the firms maximise profits by choosing a function that relates their output to the market price. Green and Newbery analyse this both theoretically and using reasonable parameter values for the British market. They show the difference between having two firms, rather than five in the market, in terms of company profits and deadweight losses. This paper provided early formal analysis of the failure of the government to break the CEGB up into enough firms to create a truly competitive market, a process that was eventually achieved by a combination of new entry and forced divestitures by 2001.

If the creation of a competitive wholesale market was one central plank of electricity liberalisation championed by David, a second general plank—also a favourite point of David’s—was the creation of an effective regulatory environment, where newly privatised network monopolies could invest in the knowledge that they would be allowed to recover a fair return via user charges subsequently. This was one of the central ideas behind the creation of independent regulatory agencies for utility industries, including electricity. Returning to his theoretical roots, David provided a convincing analysis of the economics of regulatory commitment, in a paper with Richard Gilbert in 1994 entitled ‘The Dynamic Efficiency of Regulatory Constitutions’. Newbery and Gilbert model the dynamic game played between the regulator and the private monopoly to show the circumstances under which appropriation of private returns was more or less likely. The nice point about this paper is that it models the fact that private companies are more likely to be present when they can provide the network service at lower cost (than if they were nationalised), investment requirements are growing, and where the social discount rate is lower. All of these elements would make appropriation by the regulator less likely.

David spent much of the 1990s arguing for the introduction of more competition into the wholesale power market in Great Britain. Two influential papers which discussed this clearly were his 1995 ‘Power Markets and Market Power’ and his 1998 ‘Competition, Contracts, and Entry in the Electricity Spot Market’. In Newbery (1995b), he focuses on the need to break up the incumbent duopoly (something which was to effectively happen later). In Newbery (1998), he analysed the role of fixed-price contracts between new entrant generators and incumbent suppliers in promoting competition in the face of large incumbent market shares in the wholesale pool. This pointed out how the ability of entrants to sign these contracts moderated the ability of incumbents to raise prices in the pool, hence mitigating market power. This theoretical proof was supported by the empirical observation of significant new entry into the power pool in England and Wales in the early 1990s, by new generators signing long-term contracts with suppliers.

David was very interested in the measurement of the benefit of electricity liberalisation and encouraged considerable work on this at the DAE. The earliest example of this was his paper with me, published in 1997 on ‘The Restructuring and Privatisation of the CEGB—Was It Worth It?’ This was an attempt at a comprehensive social cost-benefit analysis of the CEGB privatisation, drawing on earlier work for the World Bank (Jones et al. 1990). It was based on putting the constituent parts of the CEGB back together after privatisation to construct a time series through privatisation of revenues and costs. This was then compared to a counterfactual of what might have been expected to happen in the absence of privatisation (based on trend costs and returns in the public sector). The differences between the actual and the counterfactual, including operating cost, investment, and emissions effects, were then discounted to calculate an NPV of the privatisation, which we allocated between consumers, producers, and the government. The overall result was a small but positive benefit from the privatisation (equivalent to a permanent reduction in costs of around 5%), which went to the government and the producers (with consumers losing out). It was a result which was echoed in subsequent studies of electricity privatisations.

Much of David’s later research was to draw on this initial work as he sought to communicate the lessons of the British experience to an international audience. Among the most notable of his writings was his European Economics Association Presidential Address, ‘Privatisation and Liberalisation of Network Utilities’, published in 1997. In this, he highlights the role of economists in analysing the restructuring of network utilities, noting that ‘the gap between rather abstract theoretical models and the important specific features of each utility is narrowing’ (ibid.: 381) and no doubt with a glint in his eye, ‘the variety of experiments under way in an increasing number of countries.. .offers a tempting menu of problems to keep economists intellectually stimulated, financially rewarded, and socially productive’ (ibid.).

David wrote ‘Problems of Liberalising the Electricity Industry’ in the European Economic Review in 2002 following the botched reform of the wholesale electricity market in California (supposedly based on the British model), which halted the progress of electricity market liberalisation in many countries. In this paper, he highlights a favourite theme of his later work: the importance of adequate transmission capacity to effectively increase the size of the wholesale power market. David has long had an interest in the role of transmission grids in liberalised power markets. A significant theoretical contribution on this is his 2004 paper with Richard Gilbert and Karsten Neuhoff on Allocating

Transmission to Mitigate Market Power in Electricity Networks’. The authors explore the conditions under which generators with market power should be allowed to buy capacity on transmission grids. In general, transmission capacity could be (mis-)used to reinforce incumbent generators’ market power (via foreclosure) and hence David has been an advocate of the position that generators must use their transmission capacity or ‘lose it’.

David’s clearest summary of the lessons from the British experience with electricity liberalisation is in his 2005 paper, ‘Electricity Liberalisation in Britain: The Quest for a Satisfactory Wholesale Market Design’ (Newbery 2005b). This paper details the importance of the unbundling of transmission ownership from the ownership of power plants; the need to properly price access to transmission grids; the need to address market power in power markets; how transparent power pools can promote new entry; the need to understand whether the subsequent integration of generation and retail markets is beneficial for competition; and the superiority of the competitive wholesale markets and independently regulated natural monopoly networks over the fully vertically integrated incumbents observed in the USA. David also discusses a favourite theme of his, whether the reform of the British wholesale market in 2001, which saw a compulsory power pool replaced by bilateral contracts and a balancing market, was beneficial. David argues, as he has done consistently, that this was a costly mistake, which did nothing to promote competition.

Much of David’s wisdom on liberalised electricity markets, and reflections on network utility reforms in general, is brilliantly distilled into his 2000 book, based on lectures he gave in 1995, Privatization, Restructuring, and Regulation of Network Utilities. The book remains one of the best introductions to both the theoretical and empirical economics of network industry liberalisation. David carefully distinguishes between the impacts of privatisation, competition, and regulation. He contrasts successful liberalisation with both public ownership (as seen in pre-privatisation Europe) and traditional rate-of-return regulation (as practised in the USA). David argues how each element can contribute to a successful liberalisation: privatisation makes it possible, competition handles the potentially competitive segments, and incentive regulation can regulate the remaining monopoly networks. He draws extensively on his theoretical work on regulation and his empirical studies of electricity privatisation.